Wednesday, February 15, 2012

Brooks, Trading Price Action Reversals

The third and final volume of Al Brooks’s series is Trading Price Action Reversals: Technical Analysis of Price Charts Bar by Bar for the Serious Trader (Wiley, 2012). A trader does indeed have to be serious to read all three volumes because, according to the author himself, the task is daunting: some 570,000 words.

Only half of the final volume is about trend reversals. The rest deals with day trading, the first hour (the opening range), and putting it all together, including 78 trading guidelines, some of which you may not have encountered elsewhere.

This volume is the most accessible of the three, but then my very tired eyes did a lot of work before getting here. It would be difficult to skip the first two volumes and expect to understand the third.

Brooks himself is not primarily a reversal trader. As he writes, “I prefer high-percentage trades, and my most common trades are pullback entries and trading range fades. I especially like breakouts because when they are strong the probability of follow-through is often more than 70 percent. I look less often for reversal trades, because most reversal attempts fail, but I will take a strong reversal setup.” (p. 463)

Trading a reversal can be tough. “Since traders are expecting a large move, the probability of success is often 50 percent or less. In general, when risk is held constant, a larger potential reward usually means a smaller probability of success. This is because the edge in trading is always small, and if there was a high probability of success, traders would neutralize it quickly and it would disappear within a few bars, resulting in only a small profit.” (p. 73)

Brooks both categorizes the various kinds of reversal patterns and explains what to look for in taking a reversal trade—as always, with ample chart illustrations.

He then turns to day trading, his bread and butter. He warns traders who are not yet consistently profitable against taking small scalps. “A new trader should focus primarily on swinging only the best two to five entries each day, which are usually second entries in the form of reversals at new swing highs and lows on nontrending days (maybe 80 percent of days), and spikes and pullbacks on trend days. Once a trader is consistently profitable, the next goal should be to increase the position size rather than adding lower-probability entries.” (p. 262)

Brooks suggests that the notion of ‘always in’ “might be the single most important concept in trading.” It is part and parcel of swing trading, even though not all swing traders are always in the market. As Brooks explains, “If you had to be in the market at all times, either long or short, the always-in position is whatever your current position is.” (p. 293) There are, of course, many variations on always-in trading—from trying to catch many small swings to scaling into a position in the direction of the trend.

Let me close with two of Brooks’s guidelines.

“The single most important thing that you can do all day is talk yourself out of bad trades.” (p. 529)

“Too early is always worse than too late. Since most reversals and breakouts fail, an early entry will likely fail. Since most trends go a long way, entering late is usually still a good trade.” (p. 532)

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